Why Credit Utilization Ratio Affects Your Credit Score?

Your credit score plays an important role not just in determining whether your loan gets sanctioned but also in the interest rate you pay on your loan. One of the major inputs during calculation of your credit score is your credit utilization ratio. What is credit card utilization ratio and why should it affect your credit score? What should you do if you feel credit card utilization is affecting your credit score? Let’s try to find answers to these questions.

What Is Credit Card Utilization Ratio?

As the name suggests, it simply shows how much of your available credit card limit you have utilized. For instance, let’s assume your available credit card limit is Rs 2 lacs and your outstanding as on statement date is Rs 80,000, your credit utilization (ratio) is 40%. Now, this credit utilization ratio is one of the inputs used by credit bureaus to calculate your credit. The lower the utilization, the better it is for your credit score. Since credit bureaus use proprietary techniques to evaluate your credit score, it may not be easy to pinpoint the exact weightage of this ratio in the score. Similarly, it is not explicitly specified what is a good credit utilization ratio. From what I have read, it is recommended to keep credit utilization below 30%.

Why Should Higher Credit Utilization Affect Your Credit Score?

Credit bureaus try to assess the likelihood that you will repay a loan. And credit scores are a way to quantify that likelihood and make it easier to appreciate for bankers and people like you and me. A lower score means the credit bureau thinks that you are less likely to repay the loan (as compared to someone with a high credit score). If your credit utilization levels are consistently high, it demonstrates that you have higher appetite for credit and more importantly that you are too dependent on credit. If your credit score has to represent your repayment ability, a higher credit utilization is clearly a negative. You would expect a more person with more debt (and greater dependence on debt) to have higher chances of default. 

Let’s not ignore adverse situations either. What if you lose your job? Since you are dependent on credit (or so the credit bureau feels), there is a good chance of default. As I understand, having a high utilization ratio for a  month or so may not affect your score badly. However, a consistently high utilization level may not go down well with credit bureaus.

If I pay my credit card bills on time, why should my high credit utilization be an issue? You might feel why credit utilization should be an issue if you pay your bills on time. You might also argue that the credit bureau can’t assess your credit dependence without looking at your bank balance or your overall financial position. All this while, you were using credit card to enjoy card benefits and interest-free credit period. You could have easily swipe your debit card to make those payments (and not use credit card).

You are right but the problem is that Credit Bureaus don’t have that much information about you. You must understand the credit bureaus do not have any information about your bank balance, your net worth etc. The banks or the financial institutions do not share such information with the credit bureaus. Only the information about your credit facilities (credit cards, loans) are shared with the bureaus. A credit bureau such as CIBIL calculates your credit score on the basis of this limited information it has. Therefore, the credit bureaus arrive at your credit score simply by looking at information about your credit facilities. A credit bureau will look at your payment history, credit balance, types of credit, credit enquiries etc. to assess your credit score. Since it does not have any other information about you, it can’t possibly consider other financial information about you while calculating your credit score. Therefore, it is possible that you are paying your bills in full and on time. However, your credit score may still be down since your credit utilization is consistently high. This might sound strange but you wouldn’t want credit bureaus to have all the financial information about you, would you?

What Should I Do?

Firstly, check your scores on a regular basis. Now, there is a provision that you can download a free credit report per credit bureau per calendar year. Use the facility to keep track of your credit score. If your score is low, look into the reasons.  If there are very genuine and overt reasons (defaults, late payments) for a poor credit score, try to improve your credit behaviour. If there are errors in your credit report, you can raise a dispute with credit bureaus. At the same time, follow up with the concerned credit institutions to resolve the issue at the earliest. It is possible that the reasons for a low score are not very evident. It is in such cases that you have to use judgement to understand what the real issue is. For instance, a high credit utilization is not a very obvious red signal.

If you figure out that your score is low because of potentially high credit utilization, you can take one of the following steps.

  1. Ask your existing card provider to increase your credit limit. This will automatically bring the ratio down. This might be the easiest thing to do because the bank already has access to other information about you and a past relationship to bank upon to make that decision.
  2. Apply for a new card. This can be a problem if your credit score is quite low.
  3. Use your credit card with discretion. If you want to increase limit or apply for a new card, you can perhaps use your debit card at some places to reduce utilization levels in your credit card. I assume this is an option.
  4. Another trick could be to square a bulk of your credit card expenses before the statement date. Even though I am not too sure of this, as I understand, the data is provided to credit bureaus on statement closing date basis. Therefore, even if you have used your credit card extensively but have paid off the outstanding (or a bulk of it) before the statement date, the credit bureau will get information as on statement date. Since you already settled most of the expenses, your credit card utilization ratio will be low.

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